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Docket Number

Nos. 82 Civ. 8068, 82 Civ. 8069.

Attorney(S)

Miller, Singer, Michaelson Raives, P.C., New York City, for plaintiffs; Robert M. Raives, Lawrence I. Brandes, Clifford H. Schoenberg, Steven S. Honigman, New York City, of counsel. Butler, Rubin, Newcomer, Saltarelli Boyd, Winston Strawn, Chicago, Ill., Donovan Leisure Newton Irvine, New York City, for defendants; James J. Rubin, of counsel.

Judges

Robert Lee Carter

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Smart Summary

Bellefonte Re Insurance Company v. Argonaut Insurance Company; Universal Reinsurance Company v. Argonaut Insurance Company

Factual and Procedural Background

Bellefonte Re Insurance Company ("Bellefonte") and Universal Reinsurance Company ("Universal") separately entered into reinsurance contracts with Argonaut Insurance Company ("Argonaut") on business produced by Argonaut's managing general agent, Resources Facilities, Inc. ("RFI"). Disputes arose over the validity of those reinsurance contracts and the parties' liabilities under them. The disputes were resolved by written settlement agreements (the Bellefonte–Argonaut agreement and the Universal–Argonaut agreement), each containing substantially identical mutual covenants not to sue, promising not to commence litigation "arising from or relating to any act, omission to act or transaction which occurred prior to the execution of this Agreement in connection with any and all matters arising out of the dispute regarding the . . . contracts of reinsurance."

Several years after the settlements (five years after Bellefonte's and six years after Universal's), plaintiffs sued seeking rescission ab initio of the reinsurance contracts on the ground that Argonaut failed to disclose material information: (1) that Argonaut employed RFI only after eliciting a third-party letter purporting to indemnify Argonaut for losses from RFI business, and (2) that an Argonaut vice-president, Frank Rovere, recommended against contracting with RFI because the honesty of RFI's president was suspect.

Plaintiffs also sought, in the alternative, a judicial determination that the covenants not to sue did not bar suits based on non-disclosure of material facts or that the settlement agreements were fraudulently induced. In an opinion dated January 27, 1984, the court granted Argonaut's motion for summary judgment dismissing plaintiffs' complaints, holding that the covenants plainly barred challenges to the validity of the reinsurance contracts and rejecting the fraud-based theory that the settlements were void because Argonaut did not disclose the alleged material information.

On the present motion, Argonaut sought summary judgment on its counterclaims alleging plaintiffs breached the covenants not to sue by commencing the rescission suits and sought recovery of litigation expenses, including attorney's fees, incurred in defending against those suits. Because plaintiffs' substantive claims had been dismissed, Argonaut's only asserted damages were its litigation costs.

Legal Issues Presented

Whether a party who sues in breach of a covenant not to sue is liable to the covenantee for litigation expenses (including attorney's fees) as damages for that breach.
If such recovery is potentially available, whether plaintiffs' rescission suits constituted an "obvious breach" or were brought in objective good faith (i.e., were reasonable), such that plaintiffs would not be liable for defendant's litigation expenses under the governing standard.
Which legal standard or precedent governs the question (the court considered the Second Circuit's decision in Artvale and whether California law would require a different approach).

Arguments of the Parties

Plaintiffs' Arguments

Plaintiffs sought rescission of the reinsurance contracts on the ground that Argonaut failed to disclose material information (the indemnification letter and the Rovere recommendation) at the time the reinsurance contracts were negotiated.
Plaintiffs argued that the settlement agreements were fraudulently induced because the same non-disclosure that entitled them to rescission of the reinsurance contracts also tainted their settlement agreements; they did not allege any new misrepresentations during the negotiation or execution of the settlements, but asserted nondisclosure made the settlements voidable.
Alternatively, plaintiffs contended that the phrase "the dispute regarding the . . . contracts of reinsurance" did not encompass defendant's alleged failure to disclose the indemnification letter or the Rovere recommendation, and therefore the covenants not to sue did not bar suits to rescind on those particular grounds.

Defendant's Arguments

Argonaut moved for summary judgment on counterclaims asserting that plaintiffs' rescission suits breached the covenants not to sue and sought recovery of litigation costs, including attorney's fees, incurred in defending the suits.
Implicit in the motion was the contention that, under applicable law, litigation expenses may be recoverable as damages for breach of a covenant not to sue where the covenant was intended to bar litigation and the breach deprived the covenantee of that protection.

Table of Precedents Cited

Precedent	Rule or Principle Cited For	Application by the Court
Artvale, Inc. v. Rugby Fabrics Corp., 363 F.2d 1002 (2d Cir. 1966)	Established that whether litigation expenses are recoverable for breach of a covenant not to sue depends on the parties' intent and that, absent clear contractual language to the contrary, a covenant normally functions as a shield rather than a sword; liability for costs is limited to suits brought in "obvious breach" or bad faith.	The court treated Artvale as expressing the Second Circuit's view of New York law and applied its standard (objective good faith / obvious breach test) to determine whether plaintiffs' suits were in bad faith and therefore whether defendant could recover litigation expenses.
Child v. Lincoln Enterprises, Inc., 51 Ill. App.2d 76, 200 N.E.2d 751 (4th Dist. 1964)	Representative of authorities holding that attorney's fees and incidental litigation costs are not recoverable for breach of a covenant not to sue absent express statutory or contractual authorization.	Cited as an example of courts refusing to award litigation expenses for breaches of covenants not to sue; the opinion contrasts this approach with decisions allowing recovery where the covenant's sole aim is to bar suits.
Anchor Motor Freight v. Int'l Broth. of Teamsters, Local 377, 700 F.2d 1067 (6th Cir. 1983), cert. denied	Holds that litigation expenses may be awarded as actual damages for breach of a covenant not to sue where the covenant's sole aim is to bar suit; litigation expenses are not merely incidental but the only measure of actual damages.	Cited as an example of a contrary line of authority that would permit recovery of fees; the court recognized this view but applied Artvale instead.
Winchester Drive-In Theatre, Inc. v. Warner Bros. Pictures Distributing Corp., 358 F.2d 432 (9th Cir. 1966)	Earlier Ninth Circuit decision discussed in the context of California law; plaintiffs argued it required a stricter test for awarding damages for breach of a covenant not to sue.	The court noted plaintiffs' reliance on Winchester but observed that Artvale read Winchester as addressing federal law and treated Winchester as compatible with Artvale's approach; therefore the court did not treat Winchester as requiring a different result under California law.
Borbely v. Nationwide Mut. Ins. Co., 547 F. Supp. 959 (D.N.J. 1981)	Used to support the proposition that suits brought in reasonable and good faith are not ordinarily subject to damages for breach of a covenant not to sue.	Cited as supporting authority consistent with Artvale for the proposition that reasonable, good faith suits that are later found to breach a covenant do not give rise to liability for the opponent's litigation expenses.
Le Cordon Blue, S.A. v. BPC Publishing Ltd., 451 F. Supp. 63 (S.D.N.Y. 1978)	Also cited for the principle that a party who reasonably and in good faith pursues a suit that is later found to be barred by a covenant should not be liable for the opposing party's litigation expenses.	Cited as another supporting authority aligned with Artvale's practical approach limiting awards of litigation expenses to bad-faith or obvious-breach cases.
Bellefonte Re Ins. Co. v. Argonaut Ins. Co., 581 F. Supp. 241 (S.D.N.Y. 1984)	The court's own prior summary judgment disposition addressing the breadth and clarity of the covenants not to sue and rejecting plaintiffs' fraud theory as a ground to void the settlements.	Used both as procedural background (the earlier opinion dismissed plaintiffs' substantive claims) and as a reference for the court's finding that the covenants were drafted to bar challenges to the reinsurance contracts; the present decision evaluates plaintiffs' objective reasonableness in light of that prior ruling.

Court's Reasoning and Analysis

The court began with historical and doctrinal background, noting that at early common law a covenant not to sue served only as the basis for a damages action by the covenantee when the covenant was breached; equity then enjoined forbidden suits and the law evolved to allow the covenant as a defense. The modern question presented was whether, when a covenant not to sue is breached, the covenantee may recover litigation expenses such as attorney's fees as damages.

The opinion recognized a split of authority: some courts refuse to award attorney's fees absent express statutory or contractual authorization (as exemplified by Child), while other courts (e.g., the Sixth Circuit in Anchor Motor Freight) have allowed recovery where the covenant's sole purpose is to bar suit and litigation expenses constitute the actual damages.

Because the Universal and Bellefonte settlement agreements contained choice-of-law clauses (governed by California law for Universal's agreement and New York law for Bellefonte's), and because the parties cited no controlling state precedent on the point, the court relied upon the Second Circuit's Artvale decision as articulating the relevant New York approach and found nothing in California law to compel a different result. Artvale's central premise, as the court summarized, is that recoverability turns on what the parties intended by their contract: a covenant can expressly make breach give rise to liability for litigation expenses, but ordinarily the covenant functions primarily as a shield, and absent contrary evidence is read to impose liability only for suits brought in obvious breach or in bad faith.

Applying Artvale, the court examined the text of the covenants and the record. The covenant language did not expressly impose liability for litigation expenses. There was no record evidence that plaintiffs brought their rescission suits to harass Argonaut or that they acted with subjective bad faith. Thus the determinative question became objective good faith: would a reasonable person in plaintiffs' position, familiar with the relevant facts and law, have found plaintiffs' two principal arguments plausible?

On the fraud-based argument (that nondisclosure of the indemnification letter and Rovere's recommendation not only entitled plaintiffs to rescind the reinsurance contracts but also vitiated the settlement agreements), the court concluded that, while the court itself had rejected the argument as a matter of law in an earlier opinion, it was not so patently and indisputably incorrect as to constitute objective bad faith or an "obvious breach." Specifically, plaintiffs had argued that under California law and insurance industry custom a party could not extract a covenant not to sue without first making full disclosure of material information; although the court viewed that position as incorrect, it deemed it not frivolous to the degree required to warrant awarding litigation costs.

The court expressed more doubt about plaintiffs' alternative contention that the covenants were not broad enough to bar their suits to rescind the reinsurance contracts; it found that contention rested on an "awkward, illogical and artificial interpretation" of the clear covenant language. Nonetheless, because plaintiffs had at least one reasonable, good faith theory (the fraud/ nondisclosure theory) underlying their prosecution of the rescission suits, the court concluded the suits were not in "obvious breach" of the covenants under Artvale.

Having determined plaintiffs' actions were not objectively in bad faith or an obvious breach, the court held that Argonaut could not recover litigation expenses as damages for breach of the covenants not to sue, and therefore dismissed Argonaut's counterclaims seeking those expenses.

Holding and Implications

Holding: The court ordered that DEFENDANT ARGONAUT'S COUNTERCLAIMS FOR LITIGATION EXPENSES ARE DISMISSED.

Implications:

Direct effect on the parties: Argonaut may not recover its litigation expenses (including attorney's fees) from Bellefonte or Universal for the rescission suits; the court dismissed Argonaut's counterclaims seeking those costs because plaintiffs' suits were not in "obvious breach" or in objective bad faith under the governing Artvale standard.
Procedural posture: The decision follows the court's earlier grant of summary judgment dismissing plaintiffs' substantive claims challenging the reinsurance contracts; this opinion resolves Argonaut's separate claim for damages arising from the alleged breach of the covenants not to sue.
Precedential effect: The court applied the Second Circuit's Artvale framework to both the New York and California-governed settlements in the absence of controlling state authority to the contrary. The court did not announce a new rule displacing the cited authorities but applied Artvale's "objective good faith / obvious breach" test to the facts; the opinion therefore limits recovery of litigation expenses for breach of a covenant not to sue to cases where plaintiffs' suits are in obvious breach or are brought in bad faith, unless the covenant explicitly states otherwise.

Order: IT IS SO ORDERED (May 4, 1984).

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BELLEFONTE RE INSURANCE COMPANY, Plaintiff, v. ARGONAUT INSURANCE COMPANY, Defendant. UNIVERSAL REINSURANCE COMPANY, Plaintiff,

OPINION

ROBERT L. CARTER, District Judge.

Both plaintiffs in these consolidated actions, Bellefonte Re Insurance Company ("Bellefonte") and Universal Reinsurance Company ("Universal"), contracted separately to reinsure defendant, Argonaut Insurance Company ("Argonaut"), on business generated by one of defendant's managing general agents, Resources Facilities, Inc. ("RFI"). Subsequently, the parties became embroiled in a controversy over the validity of the reinsurance contracts and over plaintiffs' liability to defendant under those contracts. These disputes were settled by written agreements, both of which contained substantially identical mutual covenants not to sue. The parties promised not to commence any litigation on claims

The Universal-Argonaut agreement was signed in December, 1976, the Bellefonte-Argonaut agreement in January, 1978.

arising from or relating to any act, omission to act or transaction which occurred prior to the execution of this Agreement in connection with any and all matters arising out of the dispute regarding the . . . contracts of reinsurance.

Nevertheless, five years after the Bellefonte-Argonaut settlement and six years after the Universal-Argonaut settlement, plaintiffs brought suit to rescind the reinsurance contracts ab initio on the ground that information material to the risks reinsured was not disclosed at the time the contracts were negotiated. Specifically, plaintiffs alleged that defendant had not informed them that Argonaut had employed RFI only after soliciting a letter from a third party that purported to indemnify Argonaut for any loss which resulted from the business generated by RFI. Plaintiffs also alleged that defendant had failed to disclose that an Argonaut vice-president, Frank Rovere, recommended that Argonaut not contract with RFI because the honesty of RFI's president was suspect.

Acknowledging the apparent bar of the covenants not to sue, plaintiffs sought, in the same complaints, judgment rescinding the settlement agreements or, alternatively, a holding that the covenants did not bar suits premised on the non-disclosure of material facts. Plaintiffs argued, first, that the settlements had been fraudulently induced. They alleged no new misrepresentation in connection with the negotiation or execution of the agreements, but contended that the same failure to disclose material information which entitled them to recission of the reinsurance contracts tainted the settlement agreements as well. In addition, plaintiffs argued that the "dispute regarding the . . . contracts of reinsurance" did not concern defendant's alleged failure to disclose the indemnification letter or the Rovere recommendation, and therefore that the covenants not to sue did not bar suit to rescind the reinsurance contracts on that particular ground.

In an opinion dated January 27, 1984, the court granted defendant's motion for summary judgment dismissing the complaint. The court ruled that the covenants not to sue expressed, in clear and unambiguous language, the parties' intention that there be no further litigation concerning the validity of, or the parties' liability under, the contracts of reinsurance, regardless of whether a claim was based on non-disclosure of material facts at the time the reinsurance contracts were negotiated, or any other theory. Because defendant was not obliged to admit to such non-disclosure in order to negotiate a settlement, and its failure to do so was the only fraud alleged in the procurement of the settlement, the court also rejected plaintiffs' claim that they were defrauded into settling.

Bellefonte Re Insurance Co. v. Argonaut Insurance Co., 581 F. Supp. 241 (S.D.N.Y. 1984) (Carter, J.).

Presently before the court is defendant's motion for summary judgment on its counterclaims, alleging that plaintiffs breached the covenants not to sue contained in the settlement agreements by suing for recission of the reinsurance contracts. As all plaintiffs' claims were dismissed, defendant has incurred no loss from the alleged breach save the cost of defending the suit. It is these litigation expenses, including attorney's fees, that defendant seeks to recover.

At early common law, a covenant not to sue, unlike a release, was no defense to a suit brought in breach of the covenant. The covenantee's only remedy was a suit for damages in which he could recover any amount that had been recovered against him in the breaching action. The obvious inefficiency of this two step process led the courts of equity to enjoin suits prohibited by a covenant not to sue, and the law courts eventually came to allow the covenant to be pleaded as a bar. See 4 Corbin on Contracts § 932 at 744 (1951). Thereafter, suits seeking damages for the breach of a covenant not to sue became rare, and few cases have considered whether a defendant who has successfully interposed a covenant not to sue as a bar to an action against him may recover his litigation expenses as damages for the breach. Some of the courts that have addressed the question have held that attorney's fees and other incidental costs of litigation are not recoverable absent express statutory or contractual authorization. Child v. Lincoln Enterprises, Inc., 51 Ill. App.2d 76, 200 N.E.2d 751, 754 (4th Dist. 1964). Others, notably the Sixth Circuit in Anchor Motor Freight v. International Brotherhood of Teamsters, Local 377, 700 F.2d 1067, 1071-72 (6th Cir. 1983), cert. denied, ___ U.S. ___, 104 S.Ct. 81, 78 L.Ed.2d 92 (1983), have held that the traditional reluctance to award fees and costs is inapplicable to a suit involving breach of a contract whose sole aim is to bar suit because litigation expenses are not recovered incidentally in such a case, but as the only measure of actual damages incurred by the aggrieved party.

The Universal and Bellefonte settlement agreements are governed by California and New York law respectively. The parties have not cited, nor has the court found, any case from either jurisdiction which states the law on this question. In Artvale, Inc. v. Rugby Fabrics Corp., 363 F.2d 1002 (2d Cir. 1966), however, when the Second Circuit confronted the issue, although it declined to state whether it relied on state or federal law, it found that "nothing in New York law would lead us to a decision different from that we would independently reach." Id. at 1007. Accordingly, the court has treated Artvale as expressing the Second Circuit's view of the relevant New York law. Lacking a California precedent and finding nothing in California law that would dictate a contrary approach, the court has also applied Artvale to its analysis of defendant's claim against Universal.

Each settlement agreement contains a choice of law clause.

Plaintiffs contend that Winchester Drive-In Theatre, Inc. v. Warner Bros. Pictures Distributing Corp., 358 F.2d 432 (9th Cir. 1966), states California law and that it requires a party seeking damages for breach of a covenant not to sue to meet a stricter test than does Artvale. The Artvale court, however, read Winchester as deciding the issue as a matter of federal law and, moreover, it treated Winchester as a precedent for its own approach. 363 F.2d at 1008 n. 2.

In Artvale, Judge Friendly began with the assumption that whether the breach of a covenant not to sue entities the injured party to recover litigation expenses from his adversary depends upon "what the parties intended by their contract." Id. at 1008. From this premise he concluded that a covenant could be drafted so as to make clear that its breach would entail liability for such expenses, but that as a matter of contractual interpretation,

to distill all this out of the usual formal covenant would be going too far; its primary function is to serve as a shield rather than as a sword. . . . In the absence of contrary evidence, sufficient effect is given to the usual covenant not to sue if, in addition to its service as a defense, it is read as imposing liability only for suits brought in obvious breach or otherwise in bad faith. . . .

Id. Thus, absent contractual language to the contrary, a party who brings an action which is ultimately held to be in breach of a covenant not to sue, but which was based on a reasonable and good faith argument either that the covenant did not bar the suit or that the covenant was obtained by unfair means, is not liable for his opponent's litigation expenses. Id.; see also Borbely v. Nationwide Mutual Insurance Co., 547 F. Supp. 959, 980-81 (D.N.J. 1981); Le Cordon Blue, S.A. v. BPC Publishing Ltd., 451 F. Supp. 63, 71 (S.D.N.Y. 1978) (Lumbard, J.).

The covenants at issue here do not, by their own terms, expressly impose liability for litigation expenses in the event of a breach. Defendant has not suggested, nor does anything in the record indicate, that plaintiffs brought this action to harass defendant, or otherwise in subjective bad faith of a similar nature. The only issue to be considered, then, is plaintiffs' objective good faith, that is, the reasonableness of plaintiffs' contentions that the settlement agreements were fraudulently induced and that their suits to rescind the reinsurance contracts were without the scope of the covenants not to sue. Only if neither of these arguments could have appeared plausible to a reasonable person in plaintiffs' position, familiar with the relevant facts and law, would a finding of objective bad faith or, in the language of the Artvale opinion, a finding that the suits to rescind the reinsurance contracts were in "obvious breach" of the covenants not to sue, be warranted.

Although the court rejected plaintiffs' argument that defendant's failure to reveal the indemnification letter and the Rovere recommendation was fraud entitling plaintiffs to recission of the settlement agreements, it cannot be said that plaintiffs' position was so patently and indisputably incorrect as to warrant the imposition of litigation costs under the Artvale standard. In its previous opinion, the court held that since plaintiffs had covenanted not to challenge the validity of the reinsurance contracts on any basis, including a failure to disclose information material to the risks reinsured, they could not claim that their promise had been fraudulently induced merely because such information had, in fact, not been disclosed. Plaintiffs had maintained that under California law and the custom and practice of the insurance industry, defendant could not extract such a promise without first making full disclosure of any material information it had previously withheld. Although that argument is, in the court's view, incorrect, it is certainly not frivolous to a degree indicative of bad faith.

The court is less certain that the same can be said of plaintiffs' argument that their suits to rescind the reinsurance contracts were not within the scope of the covenants not to sue, even if the latter were not vitiated by fraud. As noted above and explained in detail in the court's prior opinion, the covenants were drafted so as to make plain and explicit the parties' intention that all suits challenging the validity of the reinsurance contracts be barred. Plaintiffs' contention that the covenants could not be so construed the court found to depend upon an "awkward, illogical and artificial interpretation [of] a clear and straightforward document." Bellefonte Re Insurance Co. v. Argonaut Insurance Co., 581 F. Supp. 241 at 243 (S.D. N.Y. 1984) (Carter, J.).

Nevertheless, as plaintiffs had at least one reasonable good faith argument underlying their insistence that defendant should not be permitted to interpose the settlement agreements as a bar to plaintiffs' suits for recission of the reinsurance contracts, those suits were not in "obvious breach" of the covenants not to sue. Therefore, defendant's counterclaims are dismissed.

IT IS SO ORDERED.

BELLEFONTE RE INS. CO. v. ARGONAUT INS. CO., (S.D.N.Y. 1984)